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Financial crisis John H. Cochrane University of Chicago Booth School of Business House prices, investment House prices rose a lot, then fell. Residential investment (home building) fell too. It often falls first in recessions

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The crisis. I’m interested how much is financial, how much “illiquidity,” and how much a simple rise in credit risk and its premium. The fact that non financial AA does well and nonfinancial A2P2 is even worse than financial suggests the latter interpretation to me. The credit risk premium went up – and this is just about how investors feel, not about liquidity, leveraged investors, etc.

A closer view. CP rates. It differs a lot by maturity. I found it interesting that overnight financial and nonfinancial are the same. The banks were not having special problems borrowing overnight. Again, the poor A2P2 are the ones really having problems. I think the sharp drop comes when the Fed starts buying commercial paper.

Did Lehman or the Tarp speeches set off the run? This makes the case it was the TARP speeches. (With inspiration from John Taylor) It also suggests that the function of the TARP asset purchases was just to convince the markets that the government really really was going to bail out citi, not “recapitalization so they could start lending”

We worry about a crisis because “firms can’t borrow.” But of course most firms do not depend terribly on bank financing, they can issue bonds. Also, bond issues do go straight to investors – you and I can buy the Vanguard corporate bond fund if prices are good. So, what happened to these rates? The credit spread opened to huge amounts, not seen since 1982 and near Depression levels. Interestingly though it’s because government and short rates fell not so much because corporate rates rose, at least until Tarp. There is nothing that “recapitalizing the banks” will do about this.

Many markets saw “arbitrages” open up. These aren’t true arbitrages; one end is always more illiquid than the other, or has some counterparty risk, etc. But these are prices that usually are very close to each other. In each case, the leg of the arbitrage that needs cash, needs funding, or needs borrowing is underpriced. In each case, the price difference is still small enough that “long only” investors don’t really bother that much.

Why does this matter? It’s certainly a sign of illiquid markets – the usual arbitrageurs are maxed out, can’t borrow, can’t raise equity -- so strategies that try to manage risk by “we’ll sell on the way down’’ rather than buy real put options will fall apart at times like these.

It’s important to distinguish “sand in the gears,” financial dysfunction, from simple shift in the supply curve or greater credit risk. If that’s the case, fixing the banks won’t help, nor is it obvious we should help. Not every fall in quantity is a wedge between demand and supply, not every project should be funded

Which kinds of debt fell, and what can we tell about supply vs. demand vs. wedge between the two opening up?

Falls off a cliff. And in 07 (along with ABS), long before TARP etc. The originate to sell model ended. If you want to see credit quantities affected by the financial crisis this is it. These are mortgage backed securities that don’t go through FannieFreddie, thus don’t get the government guarantee. Jumbos are an example.

Controversies: Much expansion came from existing lines of credit, not new lending. Much came by taking on SPV assets from unwinding of shadow system, not new lending. And many borrowers did report trouble getting loans.